Summary
240 pages of research results, anecdotal evidence and Graham, Buffett and Icahn quotes and stories to make the case that (deep) value investing is the way to invest in stocks. Limited how-to. Read the shorter, less academic The Acquirer’s Multiple instead.
Key Takeaways
- The Icahn Manifesto: value investing in which the investor controls his own destiny.
- Buffett’s “bread-and-butter” was buying undervalued securities and selling when the undervaluation is corrected along with investment in “special situations” where the profit is dependent on corporate rather than market action.
- It is the presence or absence of a competitive advantage that allows the enterprise to resist mean reversion in its business and to continue earning super-normal returns on capital.
- Empirically, the enterprise multiple – and Greenblatt’s EBIT variation in particular – does the best job of identifying undervalued stocks.
- The better bet is the counterintuitive one: deep undervaluation anticipating mean reversion.
- Over the longer term, the role of luck diminishes and the impact of skill becomes more pronounced.
- “Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.” – Warren Buffett
- Two valuation metrics well-suited to identifying the characteristics that typically attract activists – deep undervaluation, large cash holdings, and low payout ratios are:
- Graham’s net current asset value rule
- Enterprise Multiple
- As a portfolio, companies with the conditions in place for activism offer asymmetric, market-beating returns.
What I got out of it
The Icahn Manifesto and the general approach of activist value investors (including Buffett in his early days) were new to me. The more investment books I read, the more I realize how simple (but not easy!) investing in companies and stocks actually is.
Regardless of whether you consider yourself a value or growth investor, an activist or passive investor, it all comes down to the same simple concepts:
- Proper valuation of an investment vehicle (commonly via a DCF model with good, neutral and bad scenarios)
- Finding undervalued investments
- Margin of safety
- Reversion to the mean
- Sticking to your circle of competence
- And, if needed, understanding the moat and/or catalyst of the business
Having said that, this book did little to deepen my understanding of or skill in investing. It’s a lot of fluff – repetitive research results and stories. Carlisle’s The Acquirer’s Multiple provides the same in fewer pages.
Summary Notes
Preface
The research shows that our untrained instinct is to naively extrapolate out a trend – whether it be in fundamentals like revenue, earnings, or cash flows, or in stock prices. And when we extrapolate the fundamental performance of stocks with declining earnings, we conclude that the intrinsic value must become less than the price paid. These biases – ignorance of the base case and, by extension, mean reversion – are key contributors to the ongoing returns to deep value investment.
The Icahn Manifesto
The Icahn Manifesto:
- Acquire a shareholding in a deeply undervalued company sufficiently large to influence management.
- Draw the market’s attention to the wide discount between market price and intrinsic value.
- Push management for a catalyst, like a sale of the company, a liquidation, or some other value-enhancing act.
- If management remained intransigent and the proxy contest didn’t draw the attention of other bidders, Icahn would move to put the company in play by making a tender offer, which put him in a win/win position.
- On one hand, it created a price floor in the stock. Icahn could then wait to see if other financial or strategic buyers stepped in with a higher bid to create a liquidity event for his position.
- If no other bidder emerged, Icahn could take the company private himself, providing liquidity to the other shareholders, and, presumably getting it for cheap after demonstrating that no other bidders wanted such a moribund business.
- It’s value investing in which the investor controls his own destiny, and it works.
To Graham, a stock price below liquidation value was clear evidence that the company’s management was pursuing a “mistaken policy,” and should take “corrective action, if not voluntarily, then under pressure from stockholders.”
In Security Analysis Graham outlined a clever shortcut to calculating liquidation value, which examined a company’s working capital as a rough, but usually conservative, proxy for the liquidation value. Graham called this calculation the net current asset value.
Contrarians At The Gate
To Graham, who had been brought close to ruin in the 1929 stock market crash, the best estimate of intrinsic value was the most conservative one, and the most conservative estimate of intrinsic value was a stock’s liquidation value.
Graham determined the net current asset value by calculating the company’s current assets and then deducting from that calculation all liabilities, both current and long term. Long-term asset values – for example, intangible assets and fixed assets like plants – were totally excluded from the calculation. In ordinary times, and for the vast majority of companies, the net current asset value calculated after conducting such an examination was negative, indicating a surplus of liabilities over current assets. For a small number of stocks, however, the net current asset value would be positive, indicating a surplus of cash, receivables, and inventory over all liabilities. To be considered for purchase, Graham required that a company with a net current asset surplus trade at a market capitalization no higher than two-thirds of the net current asset value. Graham found that companies satisfying the criteria – sometimes described as net nets because the market capitalization was net of the net current asset value – were often priced at significant discounts to estimates of the value that stockholders could receive in an actual sale or liquidation of the entire company.
The greater the discount from net current asset value, the greater the return.
Profitable net-net stocks significantly underperformed the loss-makers, and profitable dividend payers significantly underperformed the profitable stocks that did not pay dividends.
The net-net portfolios had fewer down years than the market.
“Value investors are always on the lookout for catalysts. While buying assets at a discount from underlying value is the defining characteristic of value investing, the partial or total realization of underlying value through a catalyst serves to reduce risk. If the gap between price and underlying value is likely to be closed quickly, the probability of losing money due to market fluctuations or adverse business developments is reduced.” – Seth Klarman in Margin of Safety
The narrowing of the discount between price and value is a phenomenon called mean reversion, and it is fundamental to deep value investment.
The analyst should be concerned primarily with values that are supported by facts and not with those that depend on expectations.
The analyst sought not to profit from the future, but to guard against it.
Warren Buffett: Liquidator To Operator
Buffett’s “bread-and-butter” was buying undervalued securities and selling when the undervaluation is corrected along with investment in “special situations” where the profit is dependent on corporate rather than market action.
“The trick is to get more quality than you pay for in price.” – Charlie Munger
Fisher advocated the use of the scuttlebutt method to identify qualitative factors that might give an investor original insight into a potential investment. Gleaned from competitors, customers, or suppliers, these qualitative considerations might include the skill of management; the utility of the research and development or technology; the business’s service ability or customer orientation; or the effectiveness of marketing. Fisher used the totality of the information garnered through the scuttlebutt method to determine the business’s ability to grow and defend its market against competitors through technological superiority, service excellence, or a consumer franchise. (Read the Common Stocks and Uncommon Profits for more on this approach.)
“The really big money tends to be made by investors who are right on qualitative decisions, but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions.” – Benjamin Graham
A business’s intrinsic value is a function of the return it generates on the capital invested in it – the higher the return on invested capital, the greater the business’s intrinsic value.
Book value tells you what has been put in; intrinsic business value estimates what can be taken out.
The rates of return that investors need from any kind of investor are directly tied to the risk-free rate that they can earn from government securities.
It is the presence or absence of a competitive advantage that allows the enterprise to resist mean reversion in its business and to continue earning super-normal returns on capital.
Skilled managers maximize a business’s intrinsic value by maximizing its return on invested capital, which means managing both the numerator (the return) and the denominator (the invested capital) over the course of the business cycle. In practice, this means paying out as much of the return as possible, and any fallow invested capital, to minimize the invested capital employed in the business. This reduces the size of the invested capital denominator and increases the ratio of return on invested capital.
Most managers, through their employment contracts, bonuses, and option grants, are de facto incentivized not to maximize the return on invested capital, but to maximize only the growth in the numerator – the earnings.
“Just quadruple the capital you commit to a savings account and you will quadruple your earnings. You would hardly expect hosannas for that particular accomplishment. Yet, retirement announcements regularly sing the praises of CEOs who have, say, quadrupled earnings of their widget company during their reign – with no more examining whether this gain was attributable simply to many years of retained earnings and the workings of compound interest. If the widget company consistently earned a superior return on capital throughout the period, or if capital employed only doubled during the CEO’s reign, the praise for him may be well deserved. But if return on capital was lackluster and capital employed increased in pace with earnings, applause should be withheld.” – Warren Buffett.
The Acquirer’s Multiple
Return on Capital = EBIT + (Net Working Capital + Net Fixed Assets)
Earnings Yield = EBIT / Enterprise Value
Earnings yield alone is very powerful, and bore out Montier’s belief as a value investor that buying bad companies at very low prices is also a perfectly viable strategy, provided, of course, they don’t go bankrupt.
Greenblatt’s earnings yield is a very good metric for identifying undervalued stocks, and, second, mean reversion is a powerful phenomenon.
Earning yield – known generally as the enterprise multiple – is better at identifying undervalued stocks than any other “price-to-a-fundamental” ratio, including price-to-book value, price-to-earnings, price-to-operating cash flow, or price-to-free cash flow.
Enterprise multiple = EBITDA / Enterprise Value
Alternative: EBIT / Enterprise Value
Empirically, the enterprise multiple – and Greenblatt’s EBIT variation in particular – does the best job of identifying undervalued stocks.
Reversion to the mean is a powerful force and it impacts return on invested capital as it does many other data series. The mean to which return on capital reverts is the cost of capital.
The simple truth: mean reversion is pervasive, and it works on financial results as it does on stock prices. On average, super-normal returns on capital revert to the mean. Only special cases avoid mean reversion, and the factors that separate the also-rans from the special cases are impossible to identify prospectively. Without Buffett’s genius for business analysis, we should be very wary of models that justify an elevated intrinsic value by a very high return on invested capital or a very high rate of growth.
The better bet is the counterintuitive one: deep undervaluation anticipating mean reversion. An appreciation of mean reversion is critical to value investment.
A Clockwork Market
Over the longer term, the role of luck diminishes and the impact of skill becomes more pronounced.
The belief in a run of tails following a series of heads is knowns as the gambler’s fallacy. This is the mistaken idea that deviations from the expected probabilities in independent trials of a random process make future deviations in the opposite direction more likely.
What an investor should pay today for a dollar to be received tomorrow can only be determined by first looking at the risk-free interest rate.
Why does high growth seem to depress stock market returns and low growth seem to generate high stock market returns? It is not that growth destroys returns, but that the market already recognizes the high-growth nation’s potential, and bids the price of its equities too high.
Trading In Glamour: The Conglomerate Era
Kahneman and Tversky found that we make decisions about uncertain future events based on three heuristics (shortcuts or rules of thumb) that help us break down complex cognitive tasks into simpler operations. Each leads us to make poor decisions about uncertain events because it leads us to consider irrelevant evidence, and in so doing diverts us from considering the underlying probabilities of the events.
- Representativeness bias. Leads us to consider only how well something matches our stereotype of that group of things.
- Availability bias. Leads us to consider only those things that can be brought to mind with ease, often because we have personal experience with them.
- Anchoring and adjusting bias. Causes us to stick with our first impression, even in the face of additional evidence that should cause us to change our view.
Catch A Falling Knife
Studies show:
- Valuation is more important than growth in constructing portfolios.
- Even in value portfolios, high growth leads to underperformance and low or no growth leads to outperformance.
It seems that the uglier the stock, the better the return, even when the valuations are comparable.
Buying well-run companies with good businesses seems to make so much sense. Buying well-run companies with good businesses at bargain prices seems to make even more sense. The research shows, however, that the better investment – rather than the better company – is the value stock, the loss-making net nets. And the better value stock, according to Lakonishok, Shleifer, and Vishny’s research, is the low- or no-growth value stock, what they describe as “contrarian value,” and what I regard as deep value; the ugliest of the ugly. What is clear is that value investing in general, and deep value investing in particular, is exceedingly behaviourally difficult.
Experts predict less reliably than they would have if they had just used the statistical prediction rule. The statistical prediction rule tends to be a ceiling from which the expert detracts, rather than a floor to which the expert adds. The reason is that when experts are given statistical prediction rules along with permission to override them, the experts find more broken legs than there really are.
The Art Of Corporate Raid
Buffett’s insights into investment and proper capital allocation allowed Berkshire to avoid making large capital expenditures in its namesake textile operation, each of which looked like an “immediate winner…measured by standard return-on-investment tests,” but offered “illusory” benefits for the reasons Buffett describes: “Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industrywide. Viewed individually, each company’s capital investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational.
After each round of investment, all the players had more money in the game and returns remained anaemic. Thus, we faced a miserable choice: huge capital investments would have helped to keep our textile business alive but would have left us with terrible returns on ever-growing amounts of capital. After the investment, moreover, the foreign competition would still have retained a major, continuing advantage in labour costs. A refusal to invest, however, would make us increasingly non-competitive, even measured against domestic textile manufacturers.”
“This devastating outcome for the shareholders indicates what can happen when much brain power and energy are applied to a faulty premise.” – Warren Buffett
“Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.” – Warren Buffett
How Hannibal Profits From His Victories
The returns to activism are strong, significantly beating the market over both the short and long term.
Research has found several indications that activism adds performance beyond stock picking.
The research is clear that activist investors, particularly those who pursue aggressive, well-defined objectives, improve both the short-term market and longer-term operating performances of the companies they target.
Applied Deep Value
Two valuation metrics well-suited to identifying the characteristics that typically attract activists – deep undervaluation, large cash holdings, and low payout ratios are:
- Graham’s net current asset value rule
- Enterprise Multiple
Research shows that investors targeting net nets with low payout ratios will outperform those targeting net nets with higher payout ratios.
The primary problem with net nets is their scarcity and small size. They are hard to find, and when they do appear, they are often too small to absorb much capital. The second strategy – the enterprise or acquirer’s multiple – embraces the same underlying philosophy as Graham’s net nets – buying stocks with liquid balance sheets trading at a significant discount to intrinsic value – but has the benefit of scaling more readily and identifying undervalued large-capitalization companies.
The “Gonzo” style of experimental journalism: use wild inventor and wilder rhetoric to amuse and entertain while making biting social observations.
The enterprise multiple identifies many undervalued companies with so-called “lazy” balance sheets and hidden or unfulfilled potential.
As a portfolio, companies with the conditions in place for activism offer asymmetric, market-beating returns.